Global: Fed’s Rate Hikes Prove Crucial in Restoring Inflation Control, Research Reveals

The Federal Reserve’s recent success in battling inflation has underscored the importance of backing verbal commitments with decisive action. According to new research presented at the Kansas City Fed’s annual conference in Jackson Hole, Wyoming, the Fed’s credibility with financial markets was bolstered not just by its words but by a series of interest rate hikes that demonstrated a genuine commitment to restoring price stability.

The research highlights that a strong perception of a central bank’s dedication to controlling inflation can make monetary policy more effective. When markets believe in a central bank’s resolve, financial conditions can adjust more rapidly, allowing inflation to be controlled with less economic disruption.

However, the trust in the U.S. central bank under Fed Chair Jerome Powell didn’t develop overnight. It was earned progressively, beginning with the Fed’s first rate hike in March 2022 and continuing as rate increases accelerated throughout the summer. This sequence of actions shifted market perceptions, convincing investors that the Fed was serious about maintaining its 2% inflation target.

Economists Michael Bauer from the San Francisco Fed, Carolin Pflueger from the University of Chicago, and Adi Sunderam from Harvard Business School conducted the research. They found that “forecasters and markets were highly uncertain about the monetary policy rule prior to ‘liftoff’ and learned about it from the Fed’s rate hikes.” The significant rate increases were crucial in altering public perception, as the strategy and policy approach of the Fed were not fully understood before the rate hikes began.

The findings serve as a cautionary tale for central banks that rely too heavily on “talk therapy”—the notion that they can influence economic outcomes solely through words and promises. While transparency and communication are valuable, they are insufficient without concrete policy actions to back them up.

Earning Public Trust

In recent years, the Fed has placed great emphasis on transparency, with numerous speeches and public statements from its officials. This approach was based on the belief that clear communication enhances public accountability and policy effectiveness.

During the recent inflationary period, Fed officials often stressed that public belief in their commitment to the inflation target would help mitigate price increases, shorten the impact of tighter monetary policy, and reduce the negative effects on employment and the broader economy.

However, the research suggests that public trust in the Fed’s commitment wasn’t automatically granted. It had to be earned through decisive action. Survey data analyzed by the researchers revealed that in 2021, even as inflation began to rise, professional forecasters were unsure how the Fed would respond, leading to expectations of a minimal reaction from the central bank.

This uncertainty began to dissipate after the Fed initiated its first rate hike in March 2022. As the Fed transitioned from modest rate increases to more substantial hikes, including four consecutive 75-basis-point increases starting in June 2022, market expectations shifted. The change was further reinforced by Powell’s firm speech at the 2022 Jackson Hole conference, where he reiterated the Fed’s commitment to its inflation target despite potential economic pain.

As confidence in the Fed’s responsiveness to inflation grew, interest rates became more sensitive to inflation data surprises. The research indicates that this increased sensitivity improved the transmission of monetary policy to the real economy and enhanced the Fed’s ability to balance inflation control with unemployment concerns.

The researchers concluded that for future policymakers, the lesson is clear: actions must back up words. “Policy rate actions contribute to, and may even be necessary for, the effectiveness of communication, particularly when uncertainty about the monetary policy framework is high,” they wrote. They suggested that the Fed could enhance its quarterly Summary of Economic Projections to make its “reaction function” more explicit. A timely policy response is critical not only for immediate financial conditions but also for signaling the seriousness of policymakers.